The same technologies that helped create a nearly seamlessly international financial market also increased both the probability and the potential cost of market volatility. The chief problem is that the openness of national financial systems and the technologies that facilitate transactions not only make it easier for investors to find places around the world to put their money–they also make it possible for investors to pull their money out of particular investments or countries very quickly. The quick withdrawal of investments can potentially have devastating consequences for the countries concerned.
The funds that investors are able to withdraw on short notice from foreign markets are often called short-term capital. International flows of short-term capital have increased at an astonishing rate over the past decade, thanks largely to new communication and IT. The buying and selling of currencies has generated perhaps the largest, and fastest-growing flows of short-term capital in recent years, with an average daily trading volume of $3.2 trillion in the foreign exchange market (Trading Basics You Should Know).
When an American visiting the United Kingdom changes some of her dollars for pounds, the British currency, she “buys” pounds and “sells” dollars, and the person or institution with which she makes the exchange “buys” dollars and “sells” pounds. The amount of dollars she will need to buy one pound is the exchange rate of the pound in terms of dollars.
Professional money traders do the same thing as an American tourist in London, though on a much larger scale and for very different purposes. Money traders who work for companies or financial institutions often buy and sell currencies to support international trade and investment transactions. Using sophisticated trading technologies, money traders are able to move large sums of currency around the world every day.
A U.S. company that needs to buy production inputs from an Italian firm, for example, needs to use some of its dollars to buy the Italian currency, or euro, that the Italian firm wants to receive in payment for its product. Other money traders, called speculators, buy and sell currencies in an effort to make money. Speculators make money by anticipating changes in the value of one currency relative to another, or by taking advantage of small differences in the values of a currency being traded at the same time in different countries.
Currency speculation can cause rapid swings in the value of a country’s currency. These currency swings can make it difficult for a country’s businesses or its trading partners to make trade and investment plans.
Large volumes of short-term capital also flow around the world in response to changing assessments of the health of national economies. If an investor fears that the exchange value of the currency of an ailing economy is likely to drop by a significant amount, he may decide he wants to get rid of stocks or bondsA certificate issued by a government or company representing a promise by the bond issuer to pay the bondholder interest in addition to the principal amount of the bond after a specified period of time. For example, a 10-year bond purchased today costs . When you “redeem” or cash in the bond after ten years, the issuer repays the principal plus interest at a rate established when the bond was issued. he owns in that country. His hope is that he can sell those foreign stocks or bondsA certificate issued by a government or company representing a promise by the bond issuer to pay the bondholder interest in addition to the principal amount of the bond after a specified period of time. For example, a 10-year bond purchased today costs . When you “redeem” or cash in the bond after ten years, the issuer repays the principal plus interest at a rate established when the bond was issued. before the relevant currency drops too much, after which the amount of other dollars or other currencies he will be able to receive in exchange for the sale of the foreign investments will be much lower.
But if many investors share the same concern about the country’s economy and decide to sell investments there at about the same time, the exchange rate of the currency will, indeed, depreciate by a large amount, and perhaps even collapse.
When the value of a country’s currency collapses, the currency loses its purchasing power relative to foreign currencies. What this means is that imported products become much more expensive. As imports rise in price, the prices for other domestic goods also typically rise. Basic necessities can end up beyond the reach of average citizens. To prevent crushing price inflation and reverse a currency’s decline, countries typically must cut government spending and increase interest rates, which can cause more pain in the short run.
The figure below shows the U.S. Dollar to Euro exchange rate over the course of a year. While the dollar is stronger than the Euro, it is still relatively weak.
The Euro Versus The Dollar Exchange Rate, 2011-2012
The United States is currently suffering from a weak dollar, partially due to the unprecedented subprime mortgage crisis. High housing prices during the early-to-mid 2000s drove many mortgage companies to offer loans to “subprime” borrowers, high-risk individuals who had lesser credit and lower incomes than “prime” borrowers. However, it was a dangerous maneuver because companies were banking on the fact that the subprime lenders could repay them through future refinancing of their homes.
When the housing bubble burst, subprime borrowers had difficulty refinancing and were unable to pay back their loans. During 2007, nearly 1.3 million properties were subject to foreclosure, up 79 percent from 2006 (U.S. Foreclosure Activity Increases 75 percent in 2007, 2008). The debt impacted mortgage lenders initially, but eventually hit banks, security firms and even foreign stock markets. The subprime fiasco yet again highlights the risk and dire consequences of economic wagers and how global these outcomes can be. The housing market is starting to return, though it has not returned to pre-crisis levels.
A former U.S. Treasury Secretary recently compared the emergence of the modern international financial system to the development of jet aircraft. Jet planes are significantly more powerful and efficient means of transportation than the ships and propellor-driven planes they replaced. Analogously, the modern international financial system can generate much more wealth and support much more business than the system that preceded it.
But just as the power and speed of jet planes can make for spectacularly destructive crashes when something goes wrong, the massive volume of transactions and rapid pace of modern financial markets can produce extraordinarily costly crises.
In an effort to minimize those costs, governments have tried to find new ways to reduce financial volatility and avert financial crises before they start. A couple of developing countries have experimented with restrictions on the outflow of capital. Most countries have been reluctant to impose new regulations on wealth-generating capital flows. They have tried instead to use new data disclosure and monitoring tools to identify signs of financial or economic weaknesses before they are able to touch off a crisis. Not surprisingly, some of these new tools rely heavily upon IT. Moreover, nations with stronger economies are now searching for new ways to further regulate their markets and economic activity, to protect against the devastating effects of global recessions.
To learn about the impact of the subprime crisis, please read the news analysis “The Subprime Mortgage Crisis and the Globalization of Real Estate” and “Behind the Financial Crisis: Causes and Fall-outs.”
13 Source: RealtyTrac, “U.S. Foreclosure Activity Increases 75 Percent In 2007,” http://www.realtytrac.com/ContentManagement/pressrelease.aspx?ChannelID=9&ItemID=3988&accnt=64847